Thursday, January 31, 2013

There is a recurringstory in the media that 150oz Tide detergent bottles are being used as money by criminals. It's a fun story and I can't resist using it to illustrate the idea of liquidity premia.

Assume that two types of detergent bottles are held in individual's inventories. Say that they are entirely similar except one bottle is harder to sell than the other. If some unexpected event were to happen, the liquid (excuse the pun) bottle of detergent can be easily sold so as to mobilize resources to deal with the event. The illiquid one can't. This ability to serve as a superior hedge against the unexpected is a valuable service.

Even if the unexpected doesn't occur, anyone holding the liquid bottle will face less stress and unease over time knowing that they are positioned to deal with any eventuality. A forward-looking individual will anticipate this stream of uncertainty-shielding services provided by the more saleable bottle, discount these streams into the present, and arrive at a value for the bottle's liquidity. This represents a liquidity premium. The more saleable of the two bottles will have a higher liquidity premium than the less saleable one and, as a result, it will earn a higher price in the market.

The source of the difference between the two bottles' liquidities and premia could be due to marketing. Say that one detergent producer has a larger advertising budget than the other and has succeeded in broadening the clientele for its bottles. The difference could also be a result of tradition. The incumbent is well-entrenched whereas the challenger is a foreign product and comes off as a bit odd. Or maybe the CEO of one of the companies has bribed the government to only purchase its brand, thereby rigging the market to make one detergent bottle more liquid than the other.

The differential between each bottle's liquidity premium isn't fixed. Marketing budgets can shrink or expand. Government officials may cease taking bribes or they may accept larger ones from the other side. Traditions fade. Alternatively, the public's perceptions about the world could change. If people become more worried about the future, they'll put more value on the liquid bottle's ability to shield from uncertainty than before. Both its liquidity premium and its price in the market will rise relative to the less saleable bottle. If, on the other hand, people feel less uncertain about the future, the liquid bottle's premium will shrink since its hedging role is less valued.

Can we arbitrage this premium differential? Selling the liquid bottle short and buying an illiquid bottle is a bet that the differential between the two will shrink. But if in the interim people become more worried about the future, or if the more liquid product enjoys an ad budget boost, then the differential will grow and the long-short position will be a loser. There is no risk-free arbitrage between the liquid and illiquid bottles.

While the differential between detergent bottle liquidity premia cannot be arbitraged away, it can be slowly competed away by other detergent products. But it is by no means an inevitability that this will occur. Building up a liquidity network takes time and resources. All sorts of money must be thrown at wrestling away the loyalties and fixed behaviors of the transacting public. The physical infrastructure to underpin the network must also be sufficient to meet demands. If a new company comes out with a bottled detergent product, it doesn't matter how snappy its advertising campaigns is if there is no distribution system to move product from A to B. All of these large fixed costs help to keep existing liquidity premia in place.

Detergent bottle liquidity premia can disappear entirely. If it becomes illegal to pass on bottles, they would lose their liquidity and no longer earn a premium. Substitutes like shampoo bottles would be bought for their liquidity yield. More interestingly, say people become so sure about the future that inventories of potentially saleable goods no longer provide any useful services. With no uncertainty, liquidity is worthless and all liquidity premia fall to 0. Because we do face some level of uncertainty in the real world, we value liquidity and put a premium on more-liquid goods like Tide detergent bottles. Individual premia are probably constantly shifting, but the society-wide aggregate liquidity premium probably stays fairly constant.

Monday, January 28, 2013

This post may get a bit rambling. It's an attempt to tie together a couple of different strands that I've been thinking and reading about.

Modern monetary theory (MMT) in a nutshell, at least as far as I see it, goes something like this. Back in the 1990s a couple of clever guys came up with the idea of a government-provided jobs guarantee. They realized that this program would be seen by the public as an expensive boondoggle requiring sky-high taxes and huge debts. Could they outflank these criticisms by finding another way to fund the jobs guarantee?

To find the funds the early MMTers worked backwards through the labyrinthine relationship between the Federal Reserve and the Treasury. What they claimed to have discovered at the end of their trek was certainly shocking. The US Treasury, they said, funds itself not by the conventional route of taxes and bonds, but by creating and directly spending fiat (i.e. inconvertible) money. Furthermore, it is not only the government's prerogative, but its obligation to spend this money into existence, since people need a stock of fiat money to pay their taxes. Bonds, contrary to what most of us think, are not a sign of government indebtedness—rather, they drain spending.

This bit of monetary jiu-jitsu is powerful because it has the ability to disarm people's instinctual aversion to expensive social programs. If all it takes to fund a jobs guarantee is that the government spend money, and debt and taxes are not the great evils we have been trained to think, then why resist it?

Most governments don't create fiat money—their central banks do. For a government to have this power, it needs to be able to force its central bank to add new money to the government account. One way to do this is for the government to print up a bond and give it to the central bank. The central bank then credits the government's account for the full amount of the bond, and now the government can spend, say on a jobs guarantee. Alternatively, the transaction can be completed without the transferral of the bond—just have the central bank automatically credit the government's account prior to spending. When the government can require its central bank to create money on its behalf, we say that they are effectively consolidated into one entity.

"The important thing to notice is that the Treasury spends before and without regard to either previous receipt of taxes or prior bond sales."

"...permanent consolidated government deficits are the theoretical and practical norm in a modern economy... Further, government spending is always financed through creation of fiat money - rather than through tax revenues or bond sales."

"While it appears that the Treasury 'needs' the tax revenue so that it can spend, that is clearly a superficial view... The government certainly does not need to have its own IOU returned before it can spend; rather, the public needs the government's IOU before it can pay taxes."

Now as their critics were quick to point out (see Lavoie, for instance), the relationship between Fed and Treasury is such that the two are not consolidated. The Treasury cannot ask the Fed to credit its account, nor can the Treasury print up a bond and give it to the Fed in exchange for spending power. The only way the Treasury can spend is by moving previously acquired funds that are held in the private banking system into its Federal Reserve account—and the only way it can acquire these funds is through taxes and bond issues. Using the Fed to print money and fund a jobs guarantee program is impossible.

The MMT wish, it would seem, was the father to the thought—Wray's 1998 tome was too hasty in consolidating the Fed and Treasury. MMTers are left with an intriguing theory of how modern money works, yet their theory corresponds to no underlying reality. That doesn't mean that MMT is without some merits. MMTers are hackers. In their efforts to reverse engineer the Fed-Treasury nexus in order to fund their pet project, they've come across plenty of interesting minutiae about monetary operations. MMT papers and blogs go into these details and are worth reading if you want to hone your understanding of the monetary system [just take anything they say about consolidation with a grain of salt].

Has the lack of overlap between Wray 1998's theory and reality stopped MMTers? Not at all. When your theory doesn't describe reality, don't bother changing your theory—change reality so that it conforms to your theory. Enter the platinum coin.

The idea of issuing a trillion dollar platinum coin rose to prominence with the onset of yet another US debt ceiling crisis. The MMT blogs hummed about the coin, a huge coin crescendo grew on Twitter, and the issue went all the way to the White House, which demurred. My hunch is that beating the debt ceiling is only a tertiary motive for MMTer excitement over the platinum coin. Far more important to them is that the platinum coin, if implemented, will effectively consolidate the Fed and Treasury, finally redeeming Wray 1998. This opens to door to their beloved jobs guarantee.

I'm not sure how MMT will evolve, but one thing we'll probably see more of is platinum coin-style activism. Though the rest of world has moved on from the coin, the MMT blogs are still buzzing about it. I'm sure more clever ways to hack the Fed-Treasury nexus will be found, thereby giving the Treasury other routes by which to force Bernanke or whomever follows him to print dollars on demand. These hack-arounds will be publicized. Perhaps a political movement will form. This wouldn't be unique. All sorts parties have formed around monetary ideas—Greenbackism, Free Silver, and Social Credit.

I've always wondered why MMTers ignore Canada. Of all the major central banks, the Bank of Canada conforms most fully to the MMT ideal. Consider this—the Bank of Canada routinely buys bonds directly from the government. The Fed, ECB, and other central banks can only buy government debt on secondary markets. This degree of consolidation goes beyond the ability to participate in bond auctions. The BoC is permitted to lend directly to both the Federal and provincial governments without requiring any security whatsoever. Section 18(j) of the Bank of Canada Act says that the Bank may

make loans to the Government of Canada or the government of any province, but such loans outstanding at any one time shall not, in the case of the Government of Canada, exceed one-third of the estimated revenue of the Government of Canada for its fiscal year, and shall not, in the case of a provincial government, exceed one-fourth of that government’s estimated revenue for its fiscal year, and such loans shall be repaid before the end of the first quarter after the end of the fiscal year of the government that has contracted the loan.

The US Treasury was once allowed to go into overdraft at the Fed, but this hasn't been permitted since 1981. And even when it could have its account credited, overdraft loans were quite limited in size and duration.

The Bank of Canada is engaged in a very MMT-like operation right now. As I wrote in an earlier post, the Federal government is currently implementing what it calls a prudential liquidity management plan. The BoC typically buys 15% or so of bonds auctioned off by the government. It does so on a non-competitive basis, meaning that it pays the average of all competitive bids submitted to the auction. The traditional 15% allocation is enough to ensure that maturing government debt held in the BoC's portfolio is replaced. In late 2011, the government asked the Bank to fund its prudential liquidity plan by raising its allocation at government bond auctions to 20%. Because this larger allocation is more than enough to make up for maturing debt, the BoC's balance sheet has been growing quite fast. At the same time, the government's account at the BoC, which usually hovers at around $2 billion, now clocks in at $11.5 billion, and by 2014 or so, should rise to $20 billion. Below is a chart of the Bank of Canada's balance sheet. Note the large jumps in government bond holdings (red) and deposits (bottom green).

MMTers might not agree with the prudential liquidity plan, but it surely represents the sort of consolidation they are so anxious to see in the US.

So what happens when the Federal government begins to spend down its prudential balances held at the BoC? Private banks will quickly realize that they have far too many clearing balances and will try to get rid of them. Canada's overnight lending rate will collapse below its target rate. In order to bring the rate back up to target, the BoC can do any number of things.

3) Ask the government to issue more bonds, depositing the proceeds at the Bank of Canada. Bonds here are fulfilling the money-draining purpose that MMTers like to emphasize.
4) Ask the government to increase taxes, depositing the proceed at the BoC. Just like bonds, taxes would be draining previously spent money.

Finally, the BoC can simply leave this spending unsterilized.

5) Rather than withdraw (i.e. sterilize) balances, let the excess supply drag the overnight rate to the deposit rate. All clearing balances now earn the deposit rate.

The BoC currently maintains a corridor system. During the day, private Canadian banks make and receive hundreds of thousands of payments. By lunch time on a normal day there will be a number of debtor and creditor banks. Debtors can settle with a creditor by borrowing clearing balances from the BoC on a collateralized basis and transferring these balances to their creditor. By the end of the day, the BoC will have typically swallowed up large amounts of collateral as it creates and lends whatever quantity of intraday clearing balances that deficit banks require.

Banks who have borrowed balances to fund a deficit are free to maintain these positions overnight, but are dissuaded from doing so because the rate which they must pay to the BoC, the bank rate, is 0.25% above the market overnight rate. Nor do surplus banks wish to keep the quantities of clearing balances they have received at the BoC overnight, since the deposit rate is 0.25% below the market rate. As a result, those banks holding clearing balances are incentivized to transfer them to those banks that are in debt to the BoC. This transfer allows the deficit banks to pay back their intraday debts to the BoC and get their collateral back. In short, BoC balances are not attractive to maintain so they reflux back to the Bank of Canada. A good visual aid is to think of the central bank as a blowfish: it blows up during the day and sucks itself back in at night when it isn't needed.

If it turns to this last solution, the Bank of Canada will be throwing away its corridor system and adopting a floor system. Steve Waldman generated plenty of discussion on hisrecentseries of blog posts on floor systems. As the Federal government spends down its $20 billion prudential balance at the BoC, all private banks will end up holding excess clearing balances. There is no way for them to contract among each other to remove this excess. Only one option remains to the banks—hold these balances overnight and receive the deposit rate. The Bank of Canada would be a permanently inflated blowfish.

If it adopts a floor, the BoC wouldn't be the first. The Federal Reserve stumbled its way into a floor system in 2008 by injecting so many reserves that it was unable to sterilize them. But a floor system is by no means universally accidental. The Reserve Bank of New Zealand chose to adopt a floor in 2006. When it maintained a corridor, the RBNZ began to notice signs of stress in the banking system that it traced to insufficient liquidity. Evidence included delayed or 'just-in-time' payments, failed settlement, collateral hoarding, and increasing use of the bank's overnight lending facility.

Between July and October 2006, the RBNZ moved to a fully "cashed up" system by injecting $7 billion worth of settlement cash on which it paid interest. Banks had typically required $3-5 billion worth of intraday credit in order to meet their payment requirements. Now that there was a permanent $7 billion worth of balances, there was no longer any need for banks to get intraday loans from the RBNZ, nor scramble for collateral to qualify for these loans. Banks ceased waiting till the end of the day to make payments. The time of day when 50% of all payments were completed was moved up by two hours compared to when the corridor system was in place. (See the RBNZ's account of this here.)
Flattening out settlement over a trading day can be desirable since settlement delays, especially if they spread from participant to participant, can be costly.

The Bank of Canada has toyed with an RBNZ-style cashed up system. In response to the credit crisis, in May 2009 the BoC injected $3 billion of excess settlement balances into the clearing system, pushing the overnight rate down to the Bank's deposit rate. This excess was removed in June 2010, a year later. We know from a presentation by former Deputy BoC Governor David Longworth that much like New Zealand, Canadian payments tended to be made earlier in the day during the period between May 2009 and June 2010. If the Federal government's prudential balances at the BoC are spent down, a decision to use the occasion to move to a floor system rather than sterilizing this spending would not be without precedent or merit.

[If you're interested on this subject, this paper relates the US experience with excess reserves. Much like Canada and New Zealand, US payments after the onset of excess reserves were more evenly distributed throughout the day.]

Back to MMT, where this whole ramble started. Much a large corporate conglomerate, MMT might benefit from being dismantled. Beholden to the jobs guarantee division, the monetary division has made unrealistic claims about the nature of consolidation. Now it is turning to monetary activism. The monetary division would be less conflicted, and therefore be taken more seriously, if it was spun off from its parent. As separate corporations, the jobs guarantee folks could focus on lobbying governments like Canada to use their central banks to fund social programs, freeing the monetary folks to focus on how monetary systems actually work. Why not deconsolidate MMT?

Friday, January 25, 2013

When my mother asked me yesterday if I was still buying the bit points, I took it as a sign that it was time for another bitcoin post.

One of the most popular reasons for owning bit points—sorry, bitcoin—is that the supply of coin is fixed whereas the supply of central bank money can be increased ad infinitum. Like an amoeba colony nearing population saturation, the bitcoin supply is growing at a decreasing rate as it approaches the magic 21 million number, the ceiling specified by designer Satoshi Nakamoto. Bitcoin advocates believe that this controlled supply effectively grounds the price of bitcoin while leaving the value of central bank money to flap in the wind.

But this ignores the mirror image of this argument. Yes, a central bank can rapidly increase the supply of notes and reserves. But blowfish-like, a central bank can just as quickly suck this supply back in—indeed, a central bank can go to the extreme of extinguishing every last liability it has ever issued. Bitcoin, on the other hand, can never be destroyed by its issuer—it has no issuer. The implications of this for the values of bitcoin and central bank money are important. I'm going to use someone else's model to show why.

Mencius Moldbug has a recent post called How Bitcoin Dies. If I'm not mistaken, he's making reference to Adam Ferguson's book When Money Dies (pdf), an account of the Weimar inflation. In any case, I agree with much of what Moldbug (his real name?) writes. Bitcoin's value is highly tenuous, and it wouldn't take much of a shock to send it to 0. I'm going to borrow Moldbug's model of a bitcoin economy and use it to explain a central-bank economy. This will help us to see the core difference between the stabilities of these two exchange media.

Moldbug starts out by imagining that there are 2 types of bitcoin users. First, there are "speculators" who hold bitcoin over time, hoping to earn a return. The second type of user, the "exchangers," only hold bitcoin for brief moments to engage in daily transactions, selling all coins to speculators at the market close. Only speculators, therefore, hold bitcoin overnight, presumably selling it back to exchangers the next morning.

If we abstract a bit from this, what Moldbug is really talking about is the two famous "functions" of money, that of serving as a store-of-value and a medium-of-exchange.

Now if speculators all flee the market at once, then desperate exchangers have no one to sell to come evening time. Bitcoin's overnight price falls to 0. Since bitcoin no longer has any purchasing power, the next day exchangers will find their bitcoin useless as an exchange media. Bitcoin becomes just bits. What might lead to this result? Moldbug hypothesizes that a government closure of the various bitcoin exchanges would spook speculators, causing them to all exit and drive the price down to 0.

I want to show why the same thing can't happen to central bank money. During the day, banks in an economy need large quantities of central bank balances for clearing and payments purposes. A central bank provides these balances to banks in return for collateral. At the end of the day, what do the banks do with these unwanted balances? Well, let's say that they sell them onwards to speculators to hold overnight. Speculators accept the trade because they think they can make a return. The next day the banks repurchase these balances in order to use them for their daily payments. This is very much like the stable bitcoin economy described above.

What happens when the speculators suddenly exit the market? Banks now have no one to sell their clearing balances to at the end of the day. As in our bitcoin case, won't the value of balances fall to 0? No. The issuing central bank will offer to buy all of the balances back.* With what? With the collateral that was originally used to buy them. Unwanted clearing balances will therefore be slurped right back up by the central bank. So long as the central bank holds adequate collateral, it will be able to suck every single clearing liability it has issued, contracting its balance sheet to 0.

This, in short, is why the bitcoin price is highly unstable whereas the price of central bank liabilities is highly stable. All that underpins the value of bitcoin is the presence of a few speculators in the market—whatever random event causes these speculators to depart will be the end of bitcoin. In the case of central bank money, the original issuer is committed to repurchase whatever is unwanted, even if speculators scramble to leave.

In real life, speculators typically don't hold central bank clearing balances overnight. Central banks usually repurchase all clearing balances back at the end of the day, returning the collateral to the banks so they can use it for the next market day. Central banks are like blowfish.** They blow themselves huge during the day in order to accommodate the needs of banks for clearing balances, then suck themselves tight at night when they aren't needed. Bitcoin is like a slowly growing amoeba. It can't contract itself when it needs to.
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PS: What about gold? If speculators all leave the gold market, demand will still be anchored overnight by those who desire gold for ornamentation, dental, and manufacturing purposes. Thus, when the market reopens next day, exchangers will find their gold still has a positive value, although probably far less than the night before.

Disclaimer: I am long bitcoin. Why? I'm curious about bitcoin and the best way to learn is by doing. Secondly, I'm speculating that before it hits $0, it could hit $50. There are a lot of people out there who don't yet realize that they'll be buying over the next months. Keynes's beauty contest and all.

*Central banks are required to ensure that the value of clearing balances stay moored to basket of consumer goods, or a CPI target. They typically do this by setting the overnight bank rate. If no one wants to contract to hold reserves overnight, the interest rate will collapse. The central bank will have to conduct open market sales - basically repurchasing clearing balances with collateral - in order to reduce the supply of clearing balances until the overnight interest rate has returned to its prior level. In any case, that's why a central bank needs to "suck" the money supply back in.** I'm borrowing the imagery from Alex Tabarrok's 2008 post, although he uses a bullfrog.

Thursday, January 24, 2013

By way of David Andolfatto's comment on my earlier post on safe assets, I stumbled onto a talk by John Moore and Nobuhiro Kiyotaki called Evil is the Root of All Money, which in turn invokes a 1978 paper by Antoin Murphy called Money in an Economy Without Banks: The Case of Ireland (pdf link). For anyone interested in the conjunction of history of economic thought and economic history, Murphy is a great resource. I definitely suggest his The Genesis of Macroeconomics.

Murphy's paper describes an interesting episode in Irish financial history. From May 1 to November 17, 1970, all banks in Ireland went on strike. This meant that Irish bank deposits were indefinitely frozen. Despite being deprived of a large chunk of their safe and liquid assets, the Irish populace managed to soldier on with little economic difficulty—according to Murphy, retail sales were barely affected by the bank closures.

Ireland filled the void vacated by frozen deposits by using uncleared cheques as a circulating medium. Cheques are normally accepted with the intention of quickly cashing or depositing them. During the strike, an Irish family could now sign and spend a cheque at the grocer for food, and the grocer in turn could pass off that family's cheque to the local pub for a beer, who in turn was free to spend it onwards. Thus cheques boomeranged around the economy, even though they could not be cleared and no one knew when the banking system would reopen.

The genius of this system is that it resorted to an unused asset to create the new circulating medium: personal credit. Says Murphy:

In a normal banking system cheques are readily acceptable because it is believed that they are drawn against known accounts and will be cleared quickly. During the bank disputes they were drawn, not against known credit accounts or allowed overdraft limits, but against the value of other uncleared cheques and/or the transactor’s view as to his creditworthiness.

The tight-knit nature of Irish society allowed for an informal credit-rating network which, according to Murphy, was underpinned by Irish public houses. At the time, there was one pub for every 190 adults. The information that various retail outlets had about their customers allowed them to verify the ability of individuals to stand by their credit. This system had a degree of sophistication, since cheques were not universally accepted but rather were graded by risk.

This illustrates one of the ideas that I was (perhaps ineptly) trying to explain in my previous post. Just as the Irish quickly fabricated safe and liquid assets when their existing ones disappeared, wouldn't a modern shortage of safe assets be remedied in a few weeks, maybe months? What is blocking the same set of powerful market forces that quickly resupplied the Ireland with safe assets from operating today? Won't a rise in existing safe asset prices provide the economy with the desired level of safety? An excess demand for safe assets just doesn't sound like it can be a chronic problem to me.

Monday, January 21, 2013

Robert the Bruce: Scottish £20 issued by Clydesdale Bank. Not legal tender

This is my last post on legal tender. It builds on my initial posts on legal tender, various comments, and discussion at Bob Murphy's blog. If you're getting to the debate a bit late, here are the first two posts.

My short answer: not really. In the US, legal tender is comprised of Federal Reserve notes and United States coin. That means that all debts can be discharged with government coins and notes. It might seem that this would impose the circulation of coins and notes on the marketplace. But as I pointed out in my initial post, debtor and creditor can easily get around legal tender rules by negotiating their own settlement media into the terms of a debt contract.

As commenter MF points out, there is one debt obligation that's tough to negotiate around: the government's tax obligation. Since citizens must pay taxes, and the government sets legal tender, surely notes and coin are forced upon the populace. In theory yes, but in practice no. The IRS asks that people do not send notes or coin to discharge their tax obligation. As a result, most taxes are paid with non-legal tender like cheques, direct deposit etc. Legal tender laws, it would seem, have no bite since the IRS itself ignores them.

But let's assume the government did indeed require tax payments in legal tender coin and notes. Let's return to my favorite McDonald's analogy (see here and here). Imagine that McDonald's Corporation forces customers to pay their "Big Mac tax" with McDonald-issued coupons. This is equivalent to a government that requires people to submit legal tender in order to discharge a tax obligation.

As I pointed out, people don't have to submit to McDonald's tax requirements, insofar as they are willing to eat at Burger King which (let's say) doesn't require coupons to pay for Whoppers. The same goes for US legal tender. If the US government requires citizens to settle their taxes with US legal tender (which, as I've pointed out above, is not the case in practice), then people can avoid this imposition by no longer doing business with the US. Go live in Scotland, which like Burger King, has no legal tender rules. Or find some other nation that doesn't have legal tender. You'll still have to pay taxes, of course, but settlement media won't be dictated to you.

As we know from Lawrence White's Free Banking in Britain, Scotland has a long history of free banking. Even today the majority of bank notes that circulate in Scotland are issued by three private banks—The Bank of Scotland, the Royal Bank of Scotland, and the Clydesdale Bank. These notes aren't legal tender. Nor are Bank of England notes, which also circulate in Scotland. For a brief time between 1954 and 1988, Bank of England notes with denominations below £5 were legal tender. But the withdrawal of the £1 notes from circulation in 1988 left Scotland with no paper legal tender. Scots accept both local Scottish notes and Bank of England notes as settlement media not because they must, but because it's convenient.

Legal tender as a free market institution?

Having shown that modern legal tender laws aren't necessarily a huge imposition on the free choice of payment media, I'll go one further and say that in a world characterized by free banking and governed by lex mercatoria (i.e. private merchant law) legal tender laws might evolve naturally as the result of market choice.

Huge amounts of debts are created in a day’s worth of business. Negotiating settlement media into each and every contract takes time, so transactors may choose to omit that bit. If so, a subsequent situation may arise in which a debtor arrives to pay a creditor, but the creditor refuses to accept the proffered settlement media, thereby forcing the debtor into unnecessary default. To avoid having court rooms being swamped by frivolous default cases, I could imagine merchant law evolving a list of common media that must always be accepted in the settlement of those debts for which a settlement medium was not already specified. If the marketplace were to accept these laws, then legal tender rules would arise in the same way that VHS beat Beta—they provide a cheap and useful set of standards around which everyone can coordinate their plans and actions.

Naturally, all sorts of interested parties would lobby jurists to have that list include their preferred asset. Nevertheless, there seems to me to be a certain “market” logic to legal tender. The real barriers to monetary freedom are not legal tender laws, but laws that restrict the issuance of notes to a monopoly issuer, and laws that force private banks to join a monopoly clearing house. But that's a different post.

First, there seems to me to be definitional issues. What is a safe asset? Beckworth, for instance, describes them as "those assets that are highly liquid and expected to maintain their value." But liquidity and riskiness are separate concepts. There are many financial instruments that are very liquid yet risky—take the S&P mini futures contract, the most liquid futures contract in the world. There are many low-risk instruments that are illiquid—a 5 year non-cashable Canadian GIC being a good example. How are we to reconcile these oppositions into one definition?

Second, it seems to me that the concept of a safety is misspecified. How do we go about classifying safety? Is it a spectrum, or are there discrete categories of safety? If a spectrum, how are we supposed to measure degrees of safety or the lack thereof? Where do we get this safety data? Next, how do we get economy-wide gradiations of safety data?

If, on the other hand, assets are to be categorized into discrete buckets of safe and non-safe, how can anyone possibly know what asset goes in each bucket? Take a vote? Whatever Gorton says? Best 4 out of 7 rock paper scissors? At what point did Italian debt go from the safe into the non-safe bucket? Or the Zim dollar? The whole process seems ad hoc and impossible to empirically verify.

But ignore all these epistemological points for now.

Let's deal first with the word shortage. If society faces a shortage of safe financial assets, won't the prices of those safe assets immediately rise and thereby remedy the shortage?* If so, where's the problem?

Imagine a basic economy in which gold is the only safe asset and everything else is risky. There's a sudden demand for safety which means that a shortage of gold simultaneously appears in individuals' portfolios. What happens? The shortage can't be filled by gold production, supply is more or less fixed. So the gold price immediately triples. There's now enough gold to satisfy everyone's demand for safe assets.

A big part of the safe asset shortage meme seems to apply specifically to collateral. In our simple economy, if for some reason the gold market is broken, just convert risky assets into safe collateral by requiring a slightly bigger haircut than before. This is RebelEconomist's point here. Next, recruit formerly uncollateralized risky assets like pianos and grandfather clocks into serving as collateral and slap a bigger hair cut on them. Do this until the demand for collateral is met. End of story.

What does a shortage in financial asset markets even look like? I've seen shortages at Toys R Us when some new item arrives and the store manager hasn't properly anticipated demand. Lineups and unhappy customers are the result. But has anyone ever seen a lineup at the bid-ask spread for AAPL? The idea is odd. If you want to buy AAPL now, just take whatever is on offer at 601. Then take whatever is on offer at 602. Then 603. Repeat until you've bought every share that has ever been issued. The same with t-bond markets. Your demand will never go unsatisfied. No shortage here.

But maybe I'm putting too much weight on the word shortage. Maybe the problem is not a shortage per se, but the underlying increase in preferences for safety. If people's taste for risk changes, market prices adjust to a new equilibrium in order to satisfy those tastes. Why must this new distribution of prices be considered an aberration? Does the safe asset problem apply equally when people express their demand for more safety by purchasing fire extinguishers, guns, and home alarm systems? Would we then be talking about a shortage of safe consumables?

And lastly, back to the epistemological issue. I don't think we can get proof that we've got too few safe assets because we haven't properly specified the concept of safety, which means we don't have good data. Without good data, we can't be confident in any pronouncements concerning safe asset shortages.

Friday, January 18, 2013

Lars Christensen's excellent post about the necessity of having a monetary constitution includes an interesting point about central bank independence:

We want central banks to stop the ad hoc’ism. In fact we don’t even like independent central banks – as we don’t want to give them the opportunity to mess up things.

Central bank independence has become the standard approach to structuring the nexus between government service-provider and central bank liquidity-provider over the last fifty years. I think a degree of independence makes a lot of sense. Running a monopoly clearing house (which is really what a central bank is) while simultaneously operating other businesses and charities (which is what a government does) presents a tremendous conflict of interest.

For instance, imagine that General Electric was granted a monopoly to operate the U.S. clearing system. Wouldn't we worry that GE might use that clearing system to support its appliance or turbine manufacturing businesses? It might, for instance, require that those borrowing clearing balances submit GE securities as collateral but not those of GE's competitors, thereby giving GE an unfair financing advantage. Or why not have the clearing house give GE an interest free loan? Member banks can't leave the clearing house for another—it's a monopoly, after all—so there are no counterbalancing forces to discipline GE should it choose to abuse its clearing house duties.

A government is no less conflicted than GE in running a nation's monopoly clearing house. In recognition of this, we hive off central banks from government by establishing strict central bank acts and operating procedures.

But as Lars points out, we shouldn't make an idol out of central banking. Without a monetary constitution, independent central banks can screw up royally. The German Reichsbank from 1921-1923, which I wrote about in How To Stop a Hyperinflation, is a great example of this.

With prices rising at around 100% a year, Rudolph Havenstein, the President of the Reichsbank, was discounting bills at a mere five percent up until July 1922. By April 1923, Havenstein had increased the discount rate to 18%, and in September to 90%, yet by then prices were doubling every two days. Businessmen only had to take out a loan from the Reichsbank, buy and hold goods, stocks, gold, or US dollars, and when the loan was due, sell whatever had been bought for devalued reichsmarks in order to settle the loan. Even with the loan costing 90% per annum, returns on these assets were so many multiples higher that the profits on this trade were huge.

Havenstein and the board of the Reichsbank had adopted a theory that the mark was depreciating due to external circumstances. According to Laidler (1998), this theory went something like this. An adverse balance of payments (due in part to reparations requirements) was causing the reichsmark to fall in international markets. This resulted in higher local wages and prices, which created a shortage of money. The Reichsbank was only resolving the shortage by passively meeting the demand for credit. Conveniently, this theory absolved the bank's low interest rates of any responsibility for the inflation.

By the fall of 1923 Germans had had enough and voted in a government who promised monetary reform. But the government ran into a problem—they couldn't get control over Havenstein. Hjalmar Schacht notes in his autobiography Confessions of "The Old Wizard" that Havenstein was not on good terms with the government and despite indications that it wished Havenstein to retire, the Reichsbank President had resisted.

Havenstein was able to dig his heels in because in May 1922, the Reichsbank's Autonomy Law had come into effect. This law effectively enshrined the Reichsbank's independence from the government and installed Havenstein for life. Germans were effectively held hostage to a 66-year old independent central banker who refused to acknowledge his responsibility to raise interest rates in order to stop a hyperinflation. Its options limited, the government decided to try hacking around the Reichsbank by creating an entirely new currency, the rentenmark. Schacht was asked to run the bank that issued these notes, the Rentenbank. Liaquat Ahamed explains this unusual situation as it stood in mid-November:

Saddled with Von Havenstein, Stresemann had simply bypassed him by creating the independent Currency Commissionership outside of the Reichsbank [to manage the Rentenbank]. And so, when the new currency was introduced on November 15, 1923, Germany found itself in the curious position of having two official currencies—the old Reichsmark and the new Rentenmark—circulating side by side, issued by two uniquely parallel central banks. At one end of town was Schacht, operating from his converted broom closet; at the other, Von Havenstein, holed up and increasingly isolated and irrelevant in the Reichsbank’s imposing red sandstone building on Jagerstrasse. Although the Reichsbank had now stopped providing money to the government, its printing presses still continued to roll out trillions of Reichsmarks to private businesses. (Lords of Finance, Chapter 10)

As I wrote in my previous article, what stopped the reichsmark inflation cold by the end of November 1923 was not the debut of Schacht's rentenmarks on November 15 but an abrupt change in the Reichsbank's policy. This rapid reversal could only happen because of the sickness and sudden death of Havenstein on November 20th from a heart attack. Hjalmar Schacht immediately exerted his presence. He ceased the Reichsbank's acceptance of notgeld and tightened credit, thereby halting the mark's slide by the end of November, a week after Havenstein's death.

The point of this story is that independent central banking is not a panacea. Yes, it's probably a good idea to set limits in order to minimize the potential for conflicts of interest between government and the monopoly clearing house. But if an independent central banker is left to follow whatever ad hoc rule (or lack thereof), the consequences can be disastrous. A monetary constitution of the sort that Lars describes is one way to solve this problem. Even better is to open up the clearing house business to competition and choice. That way irresponsible central bankers can be disciplined by the same forces that discipline irresponsible grocers, farmers, salesman, and the rest of us great unwashed—just cease doing business with them.

Thursday, January 17, 2013

We are taught these days to view John Maynard Keynes and Friedrich Hayek as diametric opposites. This meme is encouraged by the Keynes vs Hayek rap videos, or Nicolas Wapshott's book Keynes and Hayek: the Clash that Defined Modern Economics.

But when it came to the idea of moneyness, both Keynes and Hayek were in agreement.

Wrote Hayek:

although we usually assume there is a sharp line of distinction between what is money and what is not—and the law generally tries to makes such a distinction—so far as the causal effects of monetary events are concerned, there is no such clear difference. What we find is rather a continuum in which objects of various degrees of liquidity, or with values which can fluctuate independently of each other, shade into each other in the degree to which they function as money.

I have always found it useful to explain to student that it has been rather a misfortune that we describe money by a noun, and that it would be more helpful for the explanation of monetary phenomena if 'money' were an adjective describing a property which different things could possess to varying degrees. -Denationalization of Money: The Argument Refined

Wrote Keynes:

As a footnote to the above, it may be worth emphasising what has been already stated above, namely, that “liquidity” and “carrying-costs” are both a matter of degree; and that it is only in having the former high relatively to the latter that the peculiarity of “money” consists....There is, clearly, no absolute standard of “liquidity” but merely a scale of liquidity — a varying premium of which account has to be taken. -The General Theory of Employment, Interest, and Money - Chapter 17

You may have noticed that the subtitle of my blog is inspired by the Hayek quote.

Neither Keynes nor Hayek consistently applied these insights. Rather, both tended to fall back into the noun form of money, or as Keynes called it, an absolute standard of liquidity, in which there are discrete buckets into which the economist must sort items as either money or non-money, or liquidity and non-liquidity. If they had consistently applied the idea of money as an adjective, or liquidity as a matter of degree, then Hayek would have called his book Denationalization of Moneyness, and Keynes would have called his The General Theory of Employment, Interest, and Liquidity!

That Keynes and Hayek mixed the two ways of conceptualizing monetary phenomenon isn't unusual. Most economists, living or dead, think almost entirely in terms of absolute liquidity while occasionally lapsing into a relative liquidity frame of mind.

If we were to take Hayek's advice and think purely in terms of moneyness, this is how it might look. Start with the idea that all wealth is capital, not just machines and buildings but land and human beings too. The anticipated stream of services these forms of capital will throw off as they move through time can be discounted back to the present and represented as some stock dollar amount. One of those services that capital throws off is its potential to be sold, or its moneyness/liquidity. After all, when the future is clouded, having a stock of easily saleable items can lull nagging feelings of doubt and uncertainty. Summing up the discounted flows of uncertainty-shielding services that arise from an item's anticipated liquidity/moneyness provides us with that item's liquidity premium. From there, these ideas might get some good insights into business cycles or new financial products. For now, though, we're still in a money world.

Tuesday, January 15, 2013

We discussed the definition of legal tender last week. Legal tender, in short, is any medium that can always be relied on to discharge a debt. Here's the next question—how does the conferral of legal tender status on an item affect that item's value? Here are my rough thoughts.

As I did in an older post on chartal coupon money, I'm going to make use of McDonald's Corporation to illustrate monetary phenomena. Let's say McDonald's wants to create its own form of legal tender: frozen meat patties. It does so by setting the 4 inch wide, 1/4 inch thick frozen beef patty as legal tender for all its receivables. This means that anyone indebted to McDonald's has to settle their debt with legal tender patties. If they owe $1000, they have to pay with $1000 worth of beef.

Next, McDonald's requires its suppliers, many of whom are entirely dependent on McDonald's for survival, to abide by its legal tender rules. Rather than give up their relationship with McDonald's, they accept. As a result, not only can debts due to McDonald's be settled in patties—so can debts due to a number of ranchers, bakeries, farmers, wholesalers, etc who are part of the McDonald's supply chain.

These developments will immediately increase the market price of 1/4 inch frozen beef patties. Why? Given the patty's new capacity to discharge all debts due to both McDonald's and its suppliers, it will be regarded as more liquid than if it didn't have this status. Instead of storing just one box of hamburger patties for future consumption or sale, a household or restaurant might keep a second in reserve for potential debt repayments. Since it provides an extra range of liquidity services, a 1/4 inch frozen patty will thereby gain a premium over its pre-legal tender market value.

Let's say that instead of beef patties, McDonald's declares that a new intrinsically worthless issue of yellow McDonald's certificates is to be made legal tender for $100 worth of debt. Anyone can buy the certificates at McDonald's, either with cash or in kind (say by selling supplies) and use them to pay off their debts to McDonald's or its suppliers. As debts are paid off, suppliers who accumulate unneeded certificates can offload them in the secondary market where debtors who need to settle debts can buy them.

Because McDonald's and its suppliers will always accept 1 certificate to settle each $100 worth of debt, arbitrage dictates that certificates will trade near parity. After all, if the market price of certificates falls to $90, all one need do go into debt to either McDonald's or one of its suppliers to the tune of $100, purchase a $90 certificate with the proceeds, use the certificate to repay the $100 debt, and enjoy the remaining risk-free earnings of $10. Of course, if McDonald's and its suppliers limit the market's ability to borrow from them, then this limitation might reduce the effectiveness of arbitrage and cause certificates to trade at a discount.

On the other hand, if the market price of certificates rises to $110, all one need do is buy certificates from McDonald's for $100 and sell them for $110 until the gap has been closed.

In any case, what is interesting here is that legal tender laws can add a liquidity premium to an already valuable commodity, or bestow market value on worthless bits of paper. That's not to say these certificates are pure fiat. After all, what makes them valuable is that they represent a liability of sorts, acceptance of which is backed up by power. Pure fiat objects, on the other hand, are items that circulate despite being no the liability of no one and having no intrinsic usefulness whatsoever.

As long as there are unredeemed certificates, or float, McDonald's earns seigniorage profits. After all, if $1000 worth of certificates are in circulation, the company pays no interest these certificates but can invest the proceeds in interest yielding bonds. The wider the circulation of McDonald's certificates, the larger the float and juicier the profits. Other large companies will of course be interested in enjoying seigniorage, and one can imagine them also trying to exert market power over their supply chains with legal tender rules. Their ability to do so will always be counterbalanced by competition, for if seigniorage gets too onerous, McDonalds' suppliers might flee to competitor Burger King, which may have less onerous seigniorage or no legal tender rules at all.

Extreme abuse of seigniorage would eventually result in certificates being worthless. Say McDonald's gets greedy and starts to sell certificates for $110. Anyone indebted to McDonald's or one of its suppliers is thus forced into the perverse position of having to acquire a certificate for $110 in order to settle a $100 debt, giving the debtor an immediate $10 loss. As a result, no one will choose to ever indebt themselves to either McDonald's or its suppliers. Soon, all debt in the McDonald's supply chain will have expired. Certificates will be worthless since their only source of value was their ability to discharge debts—and there is no more debt to discharge.

So is modern central bank money akin to meat patties or to yellow certificates? If the former, then a $100 bill is already valuable without legal tender laws, earning only a small premium when rules confer on it legal tender status. Removing legal tender status would do little to affect its purchasing power. If the latter, then central bank money would be entirely worthless without legal tender laws.

Sunday, January 13, 2013

A couple of years ago Mike Sproul and I worked on a short project. Mike wanted to know what portion of outstanding central bank notes are actually held by the public and what percentage has been lost, destroyed in fires and foods, buried, and misplaced. The implications are that if a large percentage of notes have been destroyed over the years, then the central bank holds significant "free" assets in its vaults for which a corresponding liability no longer exists. If you're interested in what backs "money", then this amount is important.

This is a similar concept to the idea of a "breakage". Businesses that sell gift cards, which are really just liabilities of the issuer, would prefer if those cards were lost and never redeemed. After all, the issuer will no longer be on the hook for anything and can book a pure profit. Gift card liabilities that are never redeemed are called breakage. The loyalty point industry also makes use of the term breakage. Around 18% of points that loyalty point issuers sell to their partners will never be redeemed—which is huge breakage. (That statistic come from this publicly-traded loyalty point issuer.)

The term breakage also pops up in Breaking Badwhich, I should add, is one of the most realistic TV shows out there from a moneyness perspective. In the fifth episode of season two, Walt gets angry at Jesse for losing money:

Walt: So you're saying that your guy got robbed--or rather you got robbed--but it doesn't matter.Jesse: Dude, it's called breakage, okay? Like Kmart. Shit breaks.Walt: And you're thinking this is acceptable?Jesse: It's the cost of business, yo. You're sweating me over a grand?

How much breakage do central banks enjoy? Mike's idea was to use conversion data from the pre-Euro currencies like the franc, deutsche mark, and lira. As a condition of the euro's debut, each nation's national central bank (NCB) was required to withdraw its existing note issues. Any one who owned legacy bank notes was given a horizon over which they could convert them into euros.

I've pulled the amounts of legacy bank notes not submitted for conversion from the financial statements of most European NCB's. This allows us to get a rough idea of how many notes may have been lost, burnt, or buried. I've focused on the Bundesbank, the Banque de France, De Nederlansche Bank, and Banca d'Italia—which should be a sufficient sample size. Below are the numbers in chart format.

As you can see, most legacy notes have been returned to their respective NCB. Italians and French lead the pack in returning francs and lira, with only 1.23% and 0.85% of the issue still outstanding. The Dutch and the Germans have been a bit lazy, with 2.44% of all deutsche marks and 2.79% of all guilders still unconverted.

What probably explains this discrepancy between the two groups is the horizon set for conversion. All lira had to be converted by December 2011, and all francs by February 2012. If you've still got lira or francs, you've missed the window. Guilders, on the other hand, can be converted into euro until January 2032. Deutsche marks have an even wider window—unlimited. If George Jetson still has some deutsche marks, he can take them in for conversion, assuming the euro still exists in 2062. These incentives (or lack thereof) no doubt explain some of the tardiness among the Dutch and Germans. Here is a list of time limits for redemption of each national issue of bank notes.

On the question of breakage, only ~1% franc and lira bank notes were never redeemed. A large portion of this 1% has probably been retained by the collecting community. Would it be reasonable to assume at least half? Both Mike and I were surprised that after decades of issuing currency, so little was lost to fires, flooding, rotting, misplacement, and whatnot. Maybe 0.3%-0.5%? Are people really that responsible and notes that indestructible?

One reasons for this low number is that damaged central bank notes can almost always be reclaimed. As long as more than half of the note remains, banks are required to accept it for deposit. If one-half or less of the note remains, it cannot be directly deposited. The Fed refers to this as "mutilated currency". But these notes aren't valueless since owners can send it to the Bureau of Engraving and Printing where it will be examined to determine its authenticity. A letter must be enclosed with the mutilated currency explaining why it was damaged. Presumably as long as all tests are passed, the owner of a small corner of a burnt US $100 bill will be issued a brand new bill by the Bureau.

The Fed provides a hyper detailed article here on the management of cash and mutilated currency. It's so precise that it's amusing. Learn how to properly stack, band, bag, strap, and bundle notes, and see pictures of burnt, liquid damaged, buried, and chemically damaged currency like the one below.

Federal Reserve example of burnt currency

The Fed/Bureau of Engraving aren't the only institutions to adopt the policy of exchanging damaged currency—the European Central Bank does too. Perhaps these sorts of programs help explain the surprisingly low amounts of legacy European bank notes still outstanding.

The last question is this: who benefits from central bank breakage? The Banca d'Italia should be a good model for us since it just recently retired its entire issue of lira. One way for the Banca d'Italia to allocate breakage would have been for it to give the windfall to remaining bank note holders, say as a reserve fund to back the note issue going forward. Or each note holder might enjoy a special dividend if they provided evidence of their note holdings (could get complicated). Secondly, breakage could be distributed to central bank shareholders. Here is a list of Banca d'Italia's shareholders. Lastly, the Banca d'Italia could send the profits to the state. Here's what the Banca d'Italia actually did, taken from its 2011 annual report:

Accordingly, the Bank of Italy transferred the sum of €600 million to the Treasury, being the provisional balance of lira banknotes not yet presented for conversion by the deadline.

There you have it. Profits from breakage go to the state. And when we crunch the numbers, central bank breakage really doesn't amount to much.

Friday, January 11, 2013

The trillion dollar coin debate has inspired a lot of chatter about legal tender, not all of it correct. The best source on the meaning of legal tender is Dror Goldberg (the same Dror Goldberg from my Yap Stone post). His paper, Legal Tender is short and concise. Give it a read. This post is largely based off his work.

First off. If someone offers to pay you in legal tender, say a US platinum coin, are you obligated to accept it? The answer is no.

When a medium-of-exchange is denoted as legal tender, that means that it must be accepted in the discharge of certain types of debt. If you are engaged in an exchange with someone that doesn't involve the settling of debts, then legal tender laws don't apply. For example, say you walk into a corner store and offer to pay for cigarettes using legal tender platinum coins. The store owner can legally refuse to accept the coins. After all, the two of you are not settling debts—you're engaging in a spot transaction. The owner is on the right side of the law in requiring payment in, say, peanuts. Either pay him in peanuts or walk out of the store without your smokes.

According to Goldberg, legal tender laws start with non-spot transaction—those transactions in which goods & services are provided prior to final settlement, thereby creating a debt. Legal tender laws require that a creditor accept legal tender as settlement for most types of debt contracts (not all, see next paragraph). What qualifies as legal tender? In the US this includes all United States coins and currency, as well as Federal Reserve notes. In Canada, coins produced by the Royal Mint and notes issued by the Bank of Canada are legal tender (see the Currency Act). Private bank deposits are not legal tender in the US or Canada, nor are traveler's cheques or credit cards. Creditors needn't accept cheques or credit cards.

Creditors can structure contracts to avoid the obligation of accepting legal tender. All it takes is that both parties to a debt contract agree ahead of time that some alternative medium will be used to settle the debt. Say a debtor and creditor have agreed to settle three months from now in bitcoin. If after three months have passed the debtor offers to settle with a legal tender platinum coin, the creditor can refuse to accept the coin since the contract specifies BTC. Private agreement trumps legal tender laws.

Even if no alternative media has been chosen to discharge a debt, in certain situations a creditor can still refuse legal tender. In Canada, for instance, the Currency Act specifies that while $2 coins (toonies) are legal tender, they need not be accepted in the settlement of debts over $40. If a debt is larger than $25, the creditor can refuse twenty-five $1 coins (loonies). In India, a half rupee coin is only legal tender for debts less than ten rupees, which means that a creditor can refuse to accept more than twenty half-rupee coins. (See this RBI page.)

Over the years, governments have set some odd commodities to serve as legal tender. In his book Legal Tender (1903) Samuel Breckenridge notes that in 1631, the governor of Massachusetts declared that corn was to pass in payment for all debts at the market rate, unless money or beaver had been stipulated in the contract. Breckenridge goes on to write:

A little later bullets were ordered to be taken, being rated as equal each to a farthing, though no man was to be forced to take more than 12d in any one payment in this form. In 1643, likewise in Massachusetts, wampum [shell money] was given the debt-paying quality within the value of 40s at the rate of four pieces of black or eight pieces of white to a penny. Similar legislation was enacted in Connecticut and Rhode Island. In Virgina and Maryland tobacco was the commodity most universally desired, and so, in 1633, Virginia enacted that, while contracts, judgements, etc., should be reckoned in English money, they should be paid in tobacco. And a century later Maryland made tobacco a legal tender at a penny a pound, and corn at twenty cents a bushel. In North Carolina corn, pitch, tar, pork were also used at specified rates. Thus, in 1715 any one of seventeen commodities named might be used as a legal tender or in payment of taxes. (Pg 53).

Here I'm obligated to present the alternative view to Goldberg, of which Breckenridge himself provides a decent example. In his book, Breckenridge adopts the common view that legal tender laws applies to all transactions, whether these be time (credit) or cash (spot) transactions. Writes Breckenridge:

in general, it may be said that both gold and silver coins were a lawful tender; that in cash transactions the buyer, in time transactions the debtor, had the right to select the form of money to be employed. In the case of cash transactions it was found necessary to supplement this law by penal legislation and by legislation regulating prices. But in the case of time transactions, the civil power of the courts was an adequate sanction.

Who is right? Here's a quote from the Richmond Fed that settles the matter, at least in its modern US context:

However, no federal law mandates that a person or an organization must accept currency or coins as payment for goods or services not yet provided. For example, a bus line may prohibit payment of fares in pennies or dollar bills. Some movie theaters, convenience stores and gas stations as a matter of policy may refuse to accept currency of a large denomination, such as notes above $20, and as long as notice is posted and a transaction giving rise to a debt has not already been completed, these organizations have not violated the legal tender law.

It would seem that Goldberg is correct. In spot transactions—those in which a debt hasn't been created—legal tender laws don't apply. No one needs to accept your trillion dollar coin or Federal Reserve note. At least not over the counter.

Wednesday, January 9, 2013

The idea behind the trillion dollar platinum coin goes something like this. According to law, President Obama is permitted to take an ounce of platinum, which is worth around $1,500 in the market, and mint it into a collector's coin that says $1 trillion on its face. Obama then heads off to the Federal Reserve and deposits the coin at face value, his $1,500 worth of platinum having been exchanged for $1 trillion worth of fresh Fed deposits.

What is being exploited here is the difference between a collector coin's intrinsic value and its legal tender face value. Anyone who has collected American Eagle's will be aware of this difference. On its face, an Eagle is worth $50. But the coin's intrinsic value due to its gold content is well over $1600.

Do Eagle's pass at their face value or at intrinsic value? Head on over to the US Mint and you'll see that the Mint is selling $50 Eagles at their intrinsic price of $1,900 or so. Coin dealer American Gold Exchange is hocking 1 oz Eagles for $1750. Aren't the Mint and and American Gold Exchange breaking the law in selling coins so far from face value? Not really. Legal tender laws stipulate the sorts of payment media required in the discharge of debt obligations. In selling collectors coins in retail spot transactions, the Mint isn't engaged in the activity of discharging debts. Nor is American Gold Exchange.

Think about the implications of requiring coin dealers and the US Mint to sell Eagles at face value to all comers. Both would be providing the world with the a great risk-free arbitrage opportunity—and destroying their balance sheet in the process.

Here's another interesting anecdote about collector's coins circulating (or not) at face value. From 1997 to 2003 Robert Kahre, a resident of Las Vegas and owner of 6 construction companies, ran a scheme in which he paid wages with gold eagles at their legal tender face value. Rather than hiring someone for say $50,000 a year payable by check, Kahre paid with 45 ounces of Eagles with a total face value of $2,250 or so. Their declared income of $2,250 was so low that Kahre's workers didn't have to report their income to the IRS. At the same time, Kahre saved on payroll tax. Win-win. Except for the IRS. In May 2003, Kahre's businesses were raided by the tax authorities. Kahre was at first acquitted in 2007, but in 2009 he was found guilty of tax evasion and sent to prison.

The implications of the Kahre case are that despite what's said on their face, collectors coins pass at intrinsic value in the US.

The ability, indeed requirement, to ignore a collector coin's face value when engaging in transactions with these coins is a matter of common-sense self-preservation. If private coin shops like American Gold Exchange, the US Mint, or the IRS were required to let eagles pass at face value they would all suffer tremendous losses. Likewise, if the market price of an ounce of gold fell to $2, those obliged to accept Eagles at their $50 face value would quickly go bankrupt. Face value on collectors coins is merely symbolic, not obligatory.

With the rest of the US already passing collector coins at their intrinsic value, why would Ben Bernanke be expected to accept a platinum collector coin worth $1,500 at its face value of $1 trillion? He has no obligation to do so. As I pointed out, legal tender refers to the types of media that can be used to discharge debts, and Bernanke is not indebted to Obama in any way. All he does is administer the Treasury's account at the Fed.

Nor can Bernanke choose to forgo self-preservation. Section 16.2 of the Federal Reserve Act obligates him to protect the Fed's balance sheet by stipulating the rules concerning Federal Reserve note collateralization. The Act requires that all notes must be backed by

collateral in amount equal to the sum of the Federal Reserve notes thus applied for and issued pursuant to such application... In no event shall such collateral security be less than the amount of Federal Reserve notes applied for.

This means that notes cannot be backed by an insufficient amount of collateral security. There is a long history behind section 16.2. I've discussed it before here and here. 16.2 has been liberalized over the decades. In the old days, only a small range of assets could stand as collateral, but now almost any asset can back the note issue. Nevertheless, the 16.2 requirement for sufficientquantity of security remains. If a collector coin's market value is only $1,500, then Section 16.2 presumably prevents Bernanke from depositing the coin in exchange for anything over $1,500 in Fed notes and deposits. Any larger amount of notes and deposits applied for and the coin fails the collateral test.

The case could be made that Bernanke would accept the trillion dollar coin if it were to represent a binding debt of the government to repay the $1 trillion loan. But in this form the coin is no more than a bond or promissory note. Instead of being written on paper, the promise is embossed on platinum. Bernanke can't directly accept government debt, no matter if its inscribed on platinum, paper, or a mere digital entry. He can only bring government debt onto his balance sheet after the market has already purchased it. These limits can be found in sections 13 and 14 of the act. Section 13, which governs the Fed's lending powers, does not give the Fed power to lend to the government, while section 14, which governs open market purchases, only allows the Fed to purchase government bonds on the open market.

Of course, we can speculate about the possibility of Bernanke accepting the trillion dollar coin until we turn blue. We only really know what he'd do when the time actually comes. Bernanke might accept the trillion dollar coin at face value, but he'd surely have both tradition and law on his side in questioning his obligation to do so. However, laws and conventions often bend and morph when circumstances dictate. The Bear Stearns transaction via Maiden Lane I and the AIG bailout via Maiden Lane II and III somehow went through, despite what would seem to be explicit warnings against such actions in the Federal Reserve Act.
Until it gets minted, I've got to hand it to the Beowulf, the originator of the trillion dollar coin idea, in having created what seems to be the econ blogosphere's most influential idea of the New Year.

[Update: In the comments with Bill W., I mentioned another bit of legalese indicating that the Fed needn't accept coin from either the government or a member bank. See section 13.1 of the Federal Reserve Act: “Any Federal reserve bank may receive from any of its member banks, or other depository institutions, and from the United States, deposits of current funds in lawful money, national-bank notes, Federal reserve notes, or checks.” More evidence that Bernanke can say no to a government deposit request. May≠must.]

Suffice it to say that traditional Yap does not have “money” in any technical sense of the word. None of the objects listed on page 1 [of Gillilland], like yar, gau, ma, or mbul, are money in any proper sense. It is certainly true that rai has been called “stone money” and that the literature which is cited (all of which is very far out-of-date) calls it “money.” And indeed, the Yapese themselves call rai “stone money.” But to call a “cow” a “dog” does not make the cow a dog. Even if the traditional European name of the object called rai is “stone money,” the most rudimentary scholarship could have established that it is not money.

He [Schneider] has postulated a definition of "money" I know not whether exclusively his or one generally accepted by his discipline. For my part I am a historian, not an anthropologist, and as stated in the title and introduction of my work I take a numismatic view. Schneider's definition of the English word "money" is too narrow and traditional to be acceptable. I am not alone and would cite scholars such as Melville J. Herskovits, Alison H. Quiggin, and Paul Einzig who have all discussed this issue and have concluded that primitive media, including rai, are within the perimeters of "money."

The above quarrel is a great example of the sorts of debate one sees amongst those who have adopted the standard money-view the world. The money-view dictates that before embarking on a monetary exploration of Yap, all valued items on the island must be split into money or non-money. This is always a controversial process. Do we add yar, gau, ma, or mbul to our "money" category, all of which Gillilland lists as media of exchange? (See first post, #5). Furness too reports that for "small change", Yapese used yar (pearl shells), and that when used in exchange, mbul, or banana fibre mats, were valued at the same rate as a rai stone three hands spans in diameter. What about coconuts? Furness writes about a trade in which "Old Ronoboi paid twenty thousand coconuts for a cooking stove 'made in Germany' of thin sheet-iron". Or should we only add rai stones to the money category, relegating coconuts and the rest to the non-money category? If so, then monetary analysis of the island of Yap begins and ends with rai.

On the other hand, if we adopt Schneider's categorization, then nothing appears in the money category, in which case we can't do monetary analysis at all since all we've got is a barter economy. This argument over the contents of the category called "money" is never-ending.

The moneyness view starts its monetary analysis of Yap from a different perspective. Rather than splitting Yap's commodities into money and non-money, we try to analyze the monetary nature, or moneyness/liquidity, of all items that were traded on Yap. According to Gillilland and Furness, this list of traded items includes not only the famous stones, but also yar, mbul, gau, and ma. We can also add a few trade commodities like bêche-de-mer (sea cucumber), turmeric, coconuts, and copra (dried coconut meat) to our list, as well as local commodities like housing materials, fishing equipment, canoes, bananas, yams, taro, and fish. Non-commodities like labour, war indemnities, funeral expenses, women, and dances were also all traded by the Yapese and find their way onto our list.

In adopting the view that the monetary nature of any item is a function of its liquidity, or its ability to be exchanged away, we shift monetary analysis from a focus on one (or a few) item(s) categorized as pure money to analyzing the relative liquidities of all items on our list. How often did each good appear in Yapese exchange? Would we see a flat distribution in which all items appear in roughly the same amount of trades, or a sloped distribution in which certain items appear in more trades? How does this distribution change over time? What sort of liquidity premia would each item have carried? For instance, if a yap stone could never be traded onwards, for how much less would the Yapese have valued that stone? What about the premia on mbul, coconuts, and labour?

So by shifting the axis of what we consider to be "monetary" from money to moneyness, we can ask ourselves a range of different questions. Nor do we need to follow Schneider and halt our monetary analysis when so-called barter prevails, since even then all goods will be liquid to some degree.

Sunday, January 6, 2013

As I pointed out in my previous post, all sorts of economists have incorporated the example of Yap stones into their monetary discourse. One of the more peculiar uses of these stones can be found in neo-chartalist L. Randall Wray's Understanding Modern Money (1998).

In Chapter 4 of his book, Wray claims that an economy becomes monetized by the introduction of state-issued tokens (what I call coupon instruments). To provide empirical support for his claim, Wray repeats the story about German administrators marking all Yap stones with paint (see previous post, #9). The Germans did so in order to motivate the Yapese to build roads. After all, in order to get the state to remove these markings from their valuable stones, the Yapese were required to provide their labour. The implications of Wray's chapter are that instead of requiring labour, the German government could just as easily have required payment in government-issued paper coupons. Thus Yap, which up till then had never been a monetary economy, would have suddenly become monetized.

Wray is in some difficulty here since Yap stones already circulated as media of exchange (see Goldberg in previous post). Thus the emergence of a monetized economy came prior to any German state-inspired monetization. This possibility is particularly harmful to Wray since he has adopted throughout his book an extreme, or "vulgar", version of chartalism in which the only way to monetize an economy is to introduce a state-issued coupon instrument. In a note, Wray tries to wriggle out of his predicament, claiming that:

Furness, almost certainly in error, called these 'stone currency' and imagined that they were used as some sort of primitive 'medium of exchange'; however, his description uncovers no evidence that there were any markets. (73)

Wray is contradicted by the anthropological evidence provided by Gillilland and Furness, who list all sorts of examples of rai acting as media of exchange. Rai were used to purchase fish, housing materials, yams, labour, women, coconuts, and many other valuable items. Yap stones original circulation as commodity media-of-exchange therefore prove Wray wrong in his extreme view that an economy can only be monetized via state-issued coupons.

Federal Reserve Bank of Cleveland's Michael Bryan wrote a paper called Island Money (2004) in which he adopts the chartalist idea that "money" is a marker, or a credit/debit, in order to explain rai. Owning a stone meant that one possessed a credit on the rest of the Yapese or, put differently, that Yap was in debt to the stone's owner. In this way rai functioned as "memory", a means by which to tabulate who owes whom. This is an old idea going back centuries but most popularly reincarnated in Narayana Kocherlakota's Money as Memory.

Now it is certainly true that credit IOUs have and continue to serve as some of society's most liquid instruments. Bank deposits are a great example. But to assume that only credit can qualify as "money" is to commit the same sin of monetary extremism that Wray commits. Bryan maintains that

rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money... Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established. Lacking intrinsic worth, Yap stones may be an especially useful object of study for students wishing to understand the significance of U.S. dollars, which, after all, have no value other than as a monetary unit; they’re what economists call an “fiat” money.

But as Goldberg has pointed out, Yap stones did have significant intrinsic value. There is no need, therefore, to accept Bryan's fallback view that within the so-called vacuum of intrinsic worthlessness, money could only earn value from its status as an IOU, or as so-called "memory".

The other problem with the Bryan's rai-as-credit story is their sheer size. Why choose something so awkward as a three meter wide stone to record an IOU? Any small token can be used to represent either smaller or larger debts. Casinos issue chips of the same size and shape representing amounts from $1 to $1000 — no casino deems it necessary to issue human-sized intrinsically valuable (gold plated?) $1000 casino chips. Rather than using huge stones as IOUs, the Yapese could have easily used verbal promises to record debts (see #8, previous post), or coconut shells emblazoned with markings. The simpler explanation for rai's value is Goldberg's: rai were intrinsically valuable for religious and aesthetic purposes.

I'm not saying that chartalism is wrong. I've pointed out before that I think the idea of coupon "money" makes some sense—even McDonald's could create chartal coupon instruments. So while you can count me in as a soft chartalist (I'm also a soft metallist, a soft monetarist, a soft Keynesian, a soft Austrian, etc), I'm not persuaded by the extreme versions of chartalism. The contortions its advocates are forced to undertake in order to explain monetary phenomena like Yap stones lead them astray.